Sept. 16 (Bloomberg) -- The Federal Reserve is considering extending a ``loan package'' to American International Group Inc., the insurer facing a cash shortage, according to a person familiar with the negotiations.

The stance by regulators is a reversal from a position they held as late as last night, and people with knowledge of the talks are ``cautiously optimistic,'' said the person, who declined to be identified because negotiations are confidential. The insurer dropped $1.01, or 21 percent, to $3.75 at 4:02 p.m. in New York Stock Exchange composite trading, paring losses from earlier in the day when the stock was down 74 percent.

Federal assistance may prop up AIG as the insurer looks to raise capital by selling units and former Chief Executive Officer Maurice ``Hank'' Greenberg seeks to take control of the New York- based company. Investors led by Greenberg said in a regulatory filing that they may consider a proxy fight or buyout as the insurer tries to stave off a collapse after its credit ratings were cut late yesterday.

``To the extent that a bridge loan or some type of liquidity provision allows AIG time to sell some assets on its balance sheet and time to maintain it's investment-grade rating at A or higher, I think it's a good move,'' Bill Gross, co-chief investment officer of Newport Beach, California-based Pacific Investment Management Co., said in a Bloomberg TV interview.

`A Necessary Step'

``The Fed doesn't have to necessarily put its own capital at risk,'' Gross said. ``We'll see what the plan says, but I think it's definitely a necessary step.''

Gross, the manager of the world's largest bond fund, may lose money if AIG defaults on its debts. His Pimco Total Return Fund guaranteed $760 million of debt issued by AIG as of June 30, according to a regulatory filing.

The person familiar with the loan discussions gave no timetable for reaching an agreement or estimate on how much money AIG would need. New York Fed spokesman Andrew Williams declined to comment and AIG spokesman Nicholas Ashooh didn't return a call seeking comment. Treasury spokeswoman Jennifer Zuccarelli had no comment.

AIG's fight to stay afloat is the latest tremor to shake the global financial industry, a day after Lehman Brothers Holdings Inc. filed for Chapter 11 bankruptcy protection and Merrill Lynch & Co. sold itself to Bank of America Corp.

Collateral Damage

The insurer may be overwhelmed by protection it sold investors on $441 billion of fixed-income investments, including $57.8 billion in securities tied to subprime mortgages. The swaps already forced $25 billion in writedowns over nine months.

The rating cuts may trigger more than $13 billion in collateral calls from debt investors who bought swaps, according to an Aug. 6 filing from New York-based AIG, intensifying pressure on CEO Robert Willumstad to raise cash.

The swaps provided profits when the housing market prospered ``for what has now turned out to be a much greater amount of risk than anybody anticipated,'' Willumstad, 63, said during an Aug. 7 conference call.

Wall Street's largest banks met at the New York Federal Reserve for a fifth day today, discussing AIG, said a spokesman for the New York Fed.

A collapse of AIG could result in $180 billion of losses to financial institutions, according to RBC Capital Markets analyst Hank Calenti. The sum would wipe out about half the capital companies have already raised to cope with the worldwide credit crunch, Calenti said in a report today titled ``Life Without AIG.'' European companies are particularly vulnerable, he said.

Credit Downgrades

S&P lowered AIG's long-term counterparty rating three grades to A- because of losses tied to home loans and concerns whether the insurer can raise enough money to meet obligations to investors who purchased credit-default swaps from the company. Moody's cut AIG's senior unsecured debt two grades to A2. Fitch Ratings lowered its assessment to A from AA-.

AIG piled up net losses totaling $18.5 billion in the past three quarters on writedowns tied to the collapse of the U.S. subprime mortgage market. The insurer has units that originate, guarantee and invest in home loans.

``AIG poses a systemic risk because it's a large counterparty in the financial system,'' said Prasad Patkar, who helps manage the equivalent of $1.8 billion at Platypus Asset Management in Sydney. ``It's too big to be allowed to fail.''

In the Aug. 6 filing, AIG outlined the implications of credit rating downgrades. A cut in its long-term senior debt ratings to A1 by Moody's and A+ by S&P would permit counterparties to make additional calls for as much as $13.3 billion of collateral, while a downgrade to A2 by Moody's, and to A by S&P would permit counterparties to call for approximately $1.2 billion of additional collateral, the company said in the filing.

`Immediate Need'

AIG has already posted $16.5 billion in collateral through July 31. A downgrade could also set off early termination of swaps with $4.6 billion in payments, AIG had said.

The round of credit-rating cuts ``further accentuates the immediate need for AIG to secure short-term funding and quickly execute sales of several of its subsidiaries,'' said Morgan Stanley analyst Nigel Dally in a note to investors today. ``Whether this is possible in a short time frame remains questionable.''

The Fed yesterday urged AIG to seek private capital, according to two people with knowledge of the discussions. Goldman Sachs Group Inc. and JPMorgan Chase & Co. were working with AIG to determine how much the New York-based insurer needs, said two more people, all of whom declined to be identified because negotiations are private.

Waiting for Answers

The insurer has issued no official statements on its capital-raising plans this week, frustrating investors.

``We expected the company to make a statement yesterday and they didn't,'' said Cliff Gallant, an insurance analyst at KBW Inc., in an interview with Bloomberg Television. ``They are waiting to have something concrete to say.'' Willumstad had previously said he'd present a turnaround plan Sept. 25.

AIG was given special permission to access $20 billion of capital in its subsidiaries to free liquidity, New York Governor David Paterson said yesterday. The insurer has one day to raise $75 billion to $80 billion, Paterson told CNBC today. The insurer may file bankruptcy tomorrow, the network said, citing unnamed people close to the company.

State Regulation

When an insurance company stumbles or fails, its operations including obligations to policyholders may be handled by state regulators. The holding company that owes money to stockholders and lenders may go through bankruptcy court procedures. That was the route followed by the units of Conseco Inc. after it filed for bankruptcy in 2002.

David Neustadt, a spokesman for state Insurance Superintendent Eric Dinallo, said AIG hadn't gotten access to cash through the New York lifeline announced yesterday.

``It would be part of a broader deal,'' Neustadt said. ``If there's no broader deal, then it doesn't happen.''

``We have seen some of the companies that serve as the bedrock of our financial system unraveling before our eyes,'' Paterson said in a news conference yesterday.

The $1 trillion-asset company has about $48.7 billion in hard-to-value holdings, and had 116,000 employees as of Dec. 31, compared with 97,000 two years earlier. In addition to selling life insurance and protecting property, AIG owns or manages about $25.7 billion of real estate including residential, industrial and retail properties. The company had private equity and hedge fund holdings of about $30 billion as of June 30.

Bonds Plunge

AIG's $2.5 billion of 5.85 percent notes due in 2018 plunged 7.8 cents to 44.8 cents on the dollar, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

The debt yields 18.5 percent, or about 15 percentage points more than similar-maturity Treasuries, Trace data show.

The Fed has hired Morgan Stanley to examine alternatives for AIG, a person familiar with the situation said. Morgan Stanley will review what role, if any, the government should play in helping the insurer, said the person, who declined to be identified because the talks are confidential.

AIG may report writedowns of $30 billion for the period ending Sept. 30, resulting in its ``worst quarter yet,'' if Lehman's bankruptcy leads to distressed sales of mortgage assets, Citigroup Inc. analyst Joshua Shanker said yesterday in a note. He downgraded AIG to ``hold'' from ``buy.''

Banking, Aircraft

The company may consider selling assets, including American General Finance, AIG's consumer lender, which could fetch more than $6 billion if the unit sold for twice its book value. AIG Investments could sell for more than $3 billion if it sold for 2.5 percent of clients' assets under management. The company's stake in reinsurer Transatlantic Holdings Inc. is worth about $2.25 billion, based on yesterday's share price.

Bank of America analyst Alain Karaoglan has said Willumstad should reconsider the decision to keep its aircraft-leasing unit, International Lease Finance Corp., which could sell for $7 billion to $14 billion. The unit was downgraded today by S&P, which may increase its cost of borrowing.

AIG rejected investments from buyout firms KKR & Co., TPG Inc. and J.C. Flowers & Co., people familiar with the talks said.

The insurer raised $20.3 billion in May by selling debt and equity, diluting the holdings of long-time investors. It's ``very hard to predict'' if AIG will need more capital, Willumstad said on Aug. 7. ``We're obviously dependant on the condition of the U.S. housing market.''

Fannie, Freddie

Last week, the U.S. Treasury seized Fannie Mae and Freddie Mac, the biggest sources of funding for U.S. mortgages, and nearly wiped out the value of their shares. AIG had $550 million to $600 million of preferred shares in the companies, said a person who declined to be identified because the insurer hadn't made a formal announcement.

Republican presidential nominee John McCain told CNBC today that there is a ``moral hazard'' in forcing taxpayers to be responsible for the poor performance of companies.

Asked whether regulators should allow AIG to fail, McCain said, ``I think you have to.''

Senate Banking Committee Chairman Christopher Dodd warned the Fed and Treasury against a rescue of AIG without checking with him first, expressing anger about past incidents where he was only informed afterwards. He also said he was skeptical that AIG merited aid while Lehman didn't.

``Tell me why this situation is different from Lehman,'' the Connecticut Democrat said today. ``I'm willing to listen.''

Greenberg's Group

Greenberg's group is also considering acquiring subsidiaries or making loans to AIG, the investors said today in a regulatory filing.

``AIG was his baby -- they took it away from him, and he's been trying to find a way to get it back,'' said Phillip Phan, professor of management at the Johns Hopkins Carey Business School in Baltimore. ``This is the perfect opportunity.''

Greenberg controls the largest stake in AIG, about 11 percent of the shares, through investment firms and personal holdings, according to Bloomberg data. Greenberg saw the value of the holdings plunge by more than $16 billion this year.

The AIG investors are reviewing their options ``in light of current circumstances relating to'' the insurer, the filing said. The group is using Perella Weinberg Partners LP as an adviser.

Greenberg ran AIG for 38 years until he was forced to retire in March 2005 amid state and federal probes into the company's accounting and sales practices.

Greenberg denies any wrongdoing in the case, which is still pending. Then-New York attorney General Eliot Spitzer dropped portions of the lawsuit in 2006 that included four other allegations tied to the investigation.

-- With reporting by Kathleen Hays, Andrew Frye, Josh Fineman, Linda Sandler, Caroline Salas, Carol Massar, Linda Shen, Christine Harper and Ellzabeth Hester in New York and Lizzie O'Leary and Rebecca Christie in Washington, Bei Hu in Hong Kong, Shani Raja in Syndey, Charlotte Kan in London and Adria Cimino in Paris. Editors: Rick Green, Dan Kraut

To contact the reporter on this story: Erik Holm in New York at eholm2@bloomberg.net; Hugh Son in New York at hson1@bloomberg.net.

Last Updated: September 16, 2008 16:48 EDT